Stocks vs. Bonds and What Matters Most
We continue to find ourselves in the second longest bull market since World War II and the second most expensive in the same period.2 However, that doesn’t mean it can’t last, as it’s also been one of the slowest bull markets, from a growth perspective. There has been plenty of discussion in the first half of 2017 around the different messaging that we appear to be getting from the stock market and bond market. We have equities near all-time highs and bonds have been rallying as well. The 10-year Treasury is actually lower from a yield perspective (2.30%), than where it started the year (2.45%), meaning that its price has risen like the S&P 500, but with less magnitude. This phenomenon may seem a bit odd given that the Federal Reserve is raising the Fed Funds rate. Aren’t we in a rising interest rate environment? For short term rates yes, but the overall economic and market conditions have resulted in a flattening yield curve where short-term rates and longer term rates don’t have the spread they might “normally” have in more of a growth-oriented, inflationary environment. This somewhat abnormal environment this late in the cycle may be getting to the heart of the issue; inflation has been slightly contracting and growth has been sub-par at best. In fact, first quarter GDP growth came in at an annualized 1.4% growth rate. According to The Conference Board, the US economy remains on track to expand at a moderate 2% pace through the second half of 2017, but this isn’t much to get excited about. In fact, Federal Reserve Chair Janet Yellen indicated recently that it would be “quite challenging” to achieve 3% US real GDP growth in the coming years.3
Why is all of this important? We are near full employment, which makes it difficult to foresee a significant increase in personal consumption, especially with a lack of significant wage growth and meaningful increase in labor-force participation. Since personal consumption accounts for roughly 70% of the GDP calculation it makes a notable improvement in GDP or a significant expansion in corporate earnings unlikely in our current circumstances. The Administration has the stated objective of changing some of the policies that inhibit growth and spending, such as decreasing regulation and lowering taxes (especially at the corporate level), but the execution has so far been very challenging.
At the end of the day, all else equal, stock prices generally track corporate earnings but tend to get ahead of themselves for periods of time, as well (see chart above).
S&P 500 Index (Blue Line) with its Trailing Twelve Month Earnings Per Share (EPS) (Red Line) Value the Past 30 Years (Macrotrends)
Will earnings catch up or will the gap widen before an eventual fall? If history is any indication, actual earnings growth vs. projected earnings growth will, for the 12th quarter in a row, likely exceed the estimated earnings growth rate4 for the second quarter. If this occurs, it should at least help support equity market valuations for the moment and continue a crucial trend that could allow for further valuation support. GDP growth, earnings, and valuation aside, an environment characterized by low inflation, low interest rates, with low growth can support higher equity multiples, such as the 17.5 forward Price-to-Earnings ratio for the S&P 500 presently. While support for the current PE multiple is good, achieving PE multiple expansion is much more challenging.
As it’s been throughout the cycle, these conditions have generally favored risk assets, i.e. stocks, although proper portfolio construction for most investors should involve the inclusion of both non-correlated and negatively correlated assets in order to accomplish financial goals dictated by one’s personal financial plan.
2 Source: Sam Stovall, Chief Equity Strategist CFRA 7-6-17 interview Asset TV
3 Source: Reuters 7/13/17
4 Source: FactSet Earnings Insight 7-7-17
